Mid-Third Quarter, 2010
Dear Clients and Friends of Grisanti Brown & Partners,
We wanted to interrupt your Summer for a short update on your portfolio investments. Since the second quarter, share prices have rallied nicely, and your portfolio has risen in value by more than 5%. Still, this remains a frustrating year for us. Our analytical work continues to verify the value of our portfolio companies, but their prices languish. We have experienced periods of frustration like this before, most notably in the late 1990s and again in late 2002, when our contrarian approach remained out of favor for a period and we underperformed the broader market. In both those instances, our investments prospered over the following years. We want you to know that our current frustration will not prevent us from continuing to make long term investments with strong upside potential. In fact, in the last several weeks we have made three such investments, as widespread pessimism has caused investors to overly discount the value of attractive businesses.
Our investment philosophy continues to maintain that the market is generally efficient but occasionally presents opportunities that can be exploited by patient investors with a concentrated approach. Owning fewer stocks will usually produce results that differ from the homogenous market, but over the long term that’s what investors want — to differ in a positive way from the general market. Over more than a decade, our long term performance has delivered on that goal, even though we occasionally suffer through bouts of underperformance. In our experience, the only way to avoid making mistakes during a period like this -- either by sticking with poor investments or giving up on eventual winners — is to continually re-examine our investment decisions. We ask questions such as: If the equity market were to close its doors for three years, would we be content to hold our investment over that period, confident that it would be worth more when trading resumed? Would we want to own the entire company at the current price? Is management navigating the current economic conditions in a prudent and pro-active manner?
All of our portfolio companies meet these tests. J.P. Morgan is a typical example of both the current frustration and (crucially) a company we are pleased to own for a multi-year period. The stock has declined from 48 to 37 in the past four months, and has now dropped below book value, a level not seen in 15 years, except for several months during the financial crisis in 2008. During that crisis, JP Morgan never experienced a losing quarter and was pro-active, raising additional capital and acquiring Washington Mutual and Bear Stearns at fire-sale prices. It is the strongest of the large banks and we believe the best managed. It is selling at about 6 times 2012 earnings, even after reducing our estimates by 15% to account for the new financial regulation law. We think the dividend will be reinstated soon, and we would be more than happy to own these shares if the market were to close for three years, yet this investment has underperformed the market and has hurt portfolio performance over the past four months.
We mentioned that we have found new investments recently. One of them is actually a return to an old investment — Microsoft — that we sold earlier this year at 31, and repurchased below 25 a week ago. In mid July, prior to our purchase, the company issued a terrific earnings report that highlighted the continued strength of two new products (Windows 7 and Office 2010), yet the stock continued to decline. This is a great cash flow story, with the company producing more than $22 billion of free cash flow a year (or more than 10% of its market capitalization). It has 15% of the value of the company in cash with virtually no debt, being one of the last AAA-rated companies in America. Its margins and market position in its main products remain enviable, in spite of negative publicity from Google and Apple. The stock is selling for less than ten times next year’s earnings, a record low valuation compared to the S&P 500’s multiple and the second lowest absolute valuation (the lowest was in March 2009) in its publicly traded history. Again, we would be pleased to own the entire company or have the market close for several years because the cash flows from Microsoft’s business would produce greater than a 10% free cash flow yield.
Last, as the spewing oil well was finally capped in the Gulf of Mexico, we purchased an initial position in BP. We realize that this investment is not without risks, but to summarize a lot of research: (1) the stock is down almost 40% from its pre-spill levels, even though liabilities will be stretched out over many years, (2) the environmental damage appears to be considerably less than was feared, (3) BP has obtained attractive prices for several foreign assets, increasing the total value of its remaining energy portfolio and (4) a probable conservative swing in the November elections will help limit legislative liability. These factors combine to give us a significant margin of safety. Again, three years from now we believe this stock will be substantially higher.
While the market volatility has brought the prices of many stocks lower this year, the expected cash flows from our portfolio companies over the long term has barely changed. At the end of the day, it is the cash produced by an investment (whether equity or fixed income) that determines its worth. The fixed income market looks very unattractive, as the cash returns there over the long term seem grossly inadequate, especially if interest rates ever rise. In these frustrating times, we take a lot of solace from the fact that many of our stocks are now as inexpensive as they were in March of 2009 (at the market bottom), when compared to the cash we estimate they will produce over the next three to five years. We will continue our research and we appreciate your support.
We wish you an enjoyable end to the Summer.
Grisanti Brown & Partners LLC